What are Alternative Investments?

2020 has been an extraordinary year in many ways.

The last one year hasn’t quite been the best when it comes to helping one live a relaxed, stress-free life.

Why, you ask?

The volatility that the public markets have experienced has definitely set investors hearts racing.

What did they resort to in that case?

What was their flight-to-safety?

It was Gold.

And why did they do that?

As trends and data suggest, each time the markets slump, gold prices shoot up significantly. This helps balance the portfolio and reduce the negative impact of the falling stock markets through diversification. Investors aimed to rebalance their portfolio through newer investment instruments that have a low correlation to the market movements.

This is exactly what Alternative Investments or “Alts”, as they’re also called, aim to do. They balance out the average returns of the portfolio and reduce the impact of market shocks.

What Are Alternative Investments?

Alternative Investments, simply meaninvestments outside the traditional marketof stocks, fixed income or cash.

They include non-traditional investment avenues such as Global Equities, Sovereign Gold Bonds (SGBs), Real Estate Investment Trusts (REITs), Cryptocurrency, Fractional Real Estate, Hedge Funds, Private Equity, Commodities, Collectibles, etc. The list goes on.

It may appear to many that Alternative Investing is only for individuals with high net-worth or is a concept too complicated for an average investor.

While that was true a few years ago, investing in “Alts” is becoming more accessible to a wider audience.

Alternative Investment options like Private Equity, Cryptocurrency, Collectibles and Hedge Funds are mainly suited to evolved investors who have a surplus left over after meeting their financial goals and have the risk appetite for such an investment.

However, retail investors are looking at SGBs and REITs in an attempt to diversify their portfolio since these are listed instruments. They offer returns both in the form of capital appreciation as well as interest/dividend income.

Why should you invest in Alternatives?

There is a lot of uncertainty and movement in the stock markets. Investors are looking at asset classes and investment instruments that have a low correlation to market uncertainties hence providing a cushion against these shocks.

  • Lower Volatility – Alts tend to be non- volatile instruments hence aiding an investor to diversify his portfolio and reduce the impact of uncertainties. Stock prices fluctuate based on a number of factors like the economy, the government policies, the political scenario, etc. These don’t necessarily have to do anything with the performance of the company. Since Alts are typically backed by a “real asset”, the fluctuations are fewer. An exception to this is trading in Global Equities, which offers geographical diversification despite being volatile in nature.
  • Higher risk adjusted returns– Albert Einstein famously said, “Compound Interest is the 8th wonder of the world.” For this wonder to play to its full potential, there needs to be a market with lower volatility. Each time the base value fluctuates the incremental returns get diminished.  Lower Volatility helps generate higher absolute returns. Even though the Average Return maybe higher for a traditional investment, the absolute return for an Alt investment will be higher due to the consistency of compounding of returns.
  • Generally Uncorrelated to the Market – Since Alts have a low correlation with stock market, the overall performance of the portfolio is not as drastically impacted by the price swings in the market. If a few assets perform well, the average returns tend to either stay stable or even go up while the markets may be seeing a downturn.
  • Passive Returns – A few asset classes under Alts have the property of providing passive income to the investor. Actively managing a portfolio requires time and expertise. By investing in Alts, one is taking advantage of specialists and leaving them to take the appropriate decisions on our investments. Investing in Real Estate or a Hedge Fund provides passive returns without requiring you to invest your time. Alternative investments like antiques, wine, and coins, etc., are unlikely to make or lose much money, thus creating an opportunity to generate passive income. 

What should you keep in mind before investing in Alternatives?

High Returns are always associated with High Risks. It is only wise to enter into Alternative Investments after performing due diligence.

Since there is a lack of historical data about risks and returns or public information about these investments, entry into this space should only be made after extensive research or with the guidance of an expert.

  • Alts have a long lock-in period wherein the money is invested for a longer duration (3-10 years) unlike stock markets where one can exit even within 24 hours of entry. It may also take some time to generate returns from an Alternative Investment.
  • Illiquidity – Since most alternative investments are not traded on the stock exchange, there may not be a readily available market to sell them at their fair price at any time that we may desire. While a stock can be sold within a few seconds at the price that it is trading at, if one was to sell a real estate property for e.g., it would take at least a few weeks to get a fair price for that asset.

Although alternative investments generally have lower transparency, investors can still benchmark their fund’s performance by looking for a benchmark similar to the strategy. There is a variety of indirect data available to make an informed decision.

Which investment strategies can be used while making Alternative Investments?

Just like there are different forms of returns while investing in Mutual Funds, different Alternative Investments cater to different types of returns.

  1. Income – These investments give a cash-on-cash return (i.e. a cash return on the total cash invested). Investing in a franchise of a company would be an ideal example of an Income Investment where there would be cash returns generated on the money invested in acquiring & operating the franchise.
  2. Growth – An investment in goods or commodities that do not generate income but thrive on large capital appreciation would classify as Growth Investment. Vintage Cars, Gold, Wine, Art, etc. would see an appreciation in their value as they age.
  3. Balanced – An investment that caters to both Income and Growth would classify as a Balanced Investment. For e.g., investing in Real Estate would generate both rental income as well as appreciation in the price of the property.

Key Facts about the Alternative Investment Market.

   

What are the types of alternative investments?

Alternative Investments fall under two broad brackets based on how they trade.

  • Public Investments – those that are traded publicly like SGBs and REITs.
  • Private Investments – Hedge Funds, Private Equity, Venture Capitals, Fractional Real Estate, Collectables, etc. which are not traded on public markets.

Here is a look at some Private Alternative Investments in detail.

  1. Hedge Funds:

Hedge Funds are, the “Mutual Funds” for High net-worth individuals. They are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors. These funds may be managed aggressively or make use of derivatives, non-traditional investment strategies or asset classes and leverage to generate high returns. They invest in relatively liquid assets and are open ended thus allowing investors to invest or withdraw capital periodically. They are relatively more expensive as they aim to deliver positive return irrespective of the markets rising or falling. The investment managers are paid a management fee as a % of the Net Asset Value (NAV) of the Fund along with a performance fee based on the increase in the fund’s NAV during the year, making them an expensive investment.

  • Private Equity:

Private Equity (PE) invests in non-publicly traded companies. The purpose of private equity is to invest growth capital into new businesses and help them restructure to accelerate growth and maximise profitability. It is an excellent investment option for those looking to change the company for the better. They take controlling interest in operating businesses. Once a turnaround is seen, exit is made either in the form of an Initial Public Offer (IPO) or through a Strategic Buy-Out (SBO) if they find an investor to take over the company.

  • Venture Capital:

Venture Capitals (VC) are a subset of PE and invest in early stage companies that have the potential for outsize growth, or are looking to expand rapidly in a new or innovative space. There is a high degree of risk involved in this investment as there is no proof of performance or profits. However, if the firm succeeds, the rewards are limitless. The difference between PE and VC is that the investment period for Venture Capitalists is longer than that of a Private Equity Investor who tends to buy and sell more frequently than a VC.

  • Real Estate:

Real estate is considered as an alternative asset, when a person buys an investment property such as office buildings, residential properties, industrial land. It is a hedge against inflation as it maintains or increases in value over time. It provides income through rentals along with growth in value through capital appreciation over time, even during periods of inflation. It thus acts as a very effective portfolio diversifier. Newer[AlU4]  avenues are opening up such as Fractional Ownership in Real Estate (just like buying units of a Mutual Fund but in this case buying units in a property), which give you access to investing in prime properties with smaller amounts. This makes it easier for retail investors to diversify their portfolio without committing large sums as investments.

  • Commodity:

Commodities are investments in natural resource such as coffee, oil & gas, gold, etc.  Since they are tangible and real income producing assets, they are immune to inflation. As the demand increases, so does their price. They can be bought directly over the exchange or via derivatives.

  • Collectibles:

A collectible is an item worth far more than what it was originally sold for, because of its rarity and popularity, as well as its condition. This is an extremely niche market and almost like a black hole. An investment in collectibles should only be made after thorough due diligence as there is no readymade market for the same. Hence, it’s it is difficult to estimate the price of the such an investment. It requires intensive market knowledge as well as patience. The key to investing lies in accurately predicting how the value will grow over time. Due to a spurt in the counterfeit market, the collectibles market is highly illiquid and the item could also potentially lose value.

Stocks have continued to serve investors with returns for the past decade. However, the volatility in 2020 puts a question on the returns for the future. Do you want to stake your entire portfolio on the same trend?

Now may be the perfect time to begin spreading your investment wings, by investigating some portfolio alternatives you haven’t considered in the past. Begin moving smaller amounts of your portfolio into potentially profitable alternatives. Understand the products and the risks thoroughly and identify the investment best suited to your risk appetite and financial requirements. Alternatives offer an opportunity to provide outsized returns.


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